Hopes pinned on bailout

The prosperity of the world’s largest economy is dependent on President Obama’s $1 trillion gamble to bail America out of its worst recession for decades, according to the Federal Reserve.

In his testimony to the US Senate, the Fed’s chairman Ben Bernanke said that America’s economy would only recover this year if Washington’s plans succeeded in nursing the financial system back to health. Mr. Bernanke explained that if the fiscal stimulus proposals worked as expected then growth could resume in the second half of the year. But he also qualified his comments by saying that “Only if that is the case, in my view, is there a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery”.

His comments coincided with a slew of poor economic data released last week that illustrated the poor state of the US economy. The Times reported that house prices fell at their fastest rate for 21 years and the country was hit by its most brutal slump in a quarter of a century at the end of last year, as consumers and businesses reined in spending. Revised official GDP figures showed that the economy shrank at an annual rate of 6.2% in the last quarter of 2008 – much worse than expected. But as The Financial Times went on to say, latest figures from around the world point to a marked global slowdown – from the eurozone to the Far East. Probably the most startling data came from Japan, where exports fell 45.7% in January compared with a year earlier – the steepest slide for fifty years. Not only were exports down significantly to the US but also to China, where the rate of growth in the world’s most dynamic economy is also slowing.

Nearer to home, consumer and business sentiment fell in the eurozone, which analysts fear is a precursor to a further slowdown. There was one piece of good news though for the region – inflation will soon undershoot the European Central Bank’s target, creating scope for substantial cuts in interest rates, according to The Financial Times. And here in the UK, expectations too are for lower rates this week when the Bank of England’s MPC meets. Economists believe the Bank will cut rates by a further 0.5%, bringing rates down to just half a percent. Any stimulus to the flagging economy will no doubt be welcomed by hard pressed businesses. The CBI revealed last week that conditions among service businesses have worsened rapidly in recent months, according to its latest survey. Plummeting sales, orders and profits across the sector are fuelling the worst job cuts for a decade.

Sickly Patient

There was more nursing care for one of the UK’s sickliest businesses last week – the government announced that it is to insure some £300bn of the Royal Bank of Scotland’s most toxic assets in an effort to stabilise the state-controlled bank. The government-backed insurance scheme means RBS will be able to inject loans and other credit assets into the arrangement in return for fresh capital. The plan is seen as a way of saving RBS from full-scale nationalisation and other UK banks are expected to avail themselves of the scheme. In return, the government will be extracting commitments for banks to lend more as part of its stimulus package to kick-start the economy. Lloyds is also expected to participate in the scheme but there were, according to The Daily Telegraph, last minute hitches delaying details of any help for the bank. The news coincided with Lloyds announcement that its newly acquired subsidiary HBoS lost £10.8bn last year, but the bank’s chairman insisted that it was a good deal.

Over in America, similar government-sponsored help for the banks means that US taxpayers could end up owning 36% of Citigroup after the US Treasury altered the terms of its $45bn holding in the bank. Fears that many banks might end up under government control have worried investors on Wall Street in recent weeks and the Obama administration has endeavoured to dampen speculation that it is planning to wrest control of Citigroup and its ilk. Those concerns meant stock markets were once again nervous, leading to falls for the major indices, but also in the currency markets; the yen fell sharply and surprisingly so too did the price of gold as it retreated from $1,000 per ounce. In the commodity markets, oil prices were volatile, swinging from a low of $37 per barrel to $44pb.

Sage Remains Optimistic

The world’s wealthiest investor, Warren Buffett – affectionately known as the Sage of Omaha – admitted that last year was difficult even for him, as his investment vehicle Berkshire Hathaway fell in value. As reported in The Sunday Telegraph, Mr. Buffett acknowledged that his decision to use derivatives to bet on the US and UK stock markets had proven ill-judged in the short-term. Fortunately though, his broad mix of insurance, utility and manufacturing businesses meant the portfolio was diversified overall. But he reminded investors that his strategy of having excess liquidity meant he would continue to buy shares and bonds from companies. “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down” he quipped, adding “We like buying underpriced securities, but we like buying fairly-priced operating businesses even more”. The latter comment was seen as a broad hint that he would be snapping up companies that had the potential for solid earnings growth in the future.

And it’s not just shares that professional investors are snapping up. According to The Financial Times, a gulf is opening up in the commercial property market between professional investors looking for opportunity in distressed assets and private investors looking to exit. The paper said that seasoned investors are saying this is the investment of a lifetime and are buying properties at heavily discounted prices. Of course, it has been worrying for private investors who have seen sharp falls in the value of their funds, but it may be that with increased professional interest the market may be stabilising. Historically, investing in commercial property has been a way of hedging against inflation and as an asset class it has outperformed both cash and government bonds, with income its main attraction. As a result of falling capital values, income yields have risen and many portfolios today are yielding c.8% to investors.

Risk Versus Reward

The stock market falls witnessed in the last eighteen months have been painful for investors, but many professional investors now see huge opportunity ahead. Nick Purves of Schroders manages UK equity funds for St. James’s Place and he explains why he is now changing his investment strategy. “Before I talk about how I see events unfolding and the potential impact on the portfolio, it’s worth just looking backwards to put current events into perspective. In the last few months things have deteriorated at a faster rate than expected, with economic indicators worse than thought. As an example, we are seeing property companies coming to the market for cash because they have been caught out, not by the falls in property values, but the speed of decline. Within the market, share prices are behaving in the way one would expect – in other words, investors are so risk averse they are selling or avoiding any stock perceived as high risk, for example financials. Usual share valuation methods are being ignored because investors don’t believe the numbers and so don’t want to own stocks, which has led to indiscriminate selling.

But looking forward, where do I see the opportunities? Firstly I don’t see my job to be one of being either pro or anti risk. What is important is to evaluate, for each share, whether the risk/reward balance is right. So 18 months ago it seemed sensible – following a period of sharp price rises – to become more defensive by moving the portfolio into sectors such as energy and telecoms. These have done very well and explain why the portfolio held up as well as it did last year. Now, however, I think investors will be compensated for taking on more risk. Warren Buffett talks about being greedy when others are fearful – currently, fear rules in the market and to take on more risk feels rather scary but you need to be brave. So within the portfolio I have bought stocks in those sectors which are very distressed, for example banks, financials, retail, industrial and media. I can buy into these companies at huge discounts to book value.

There is still risk, of course – things could get worse – so I am being careful by taking relatively small positions. I own Barclays, RBS and Lloyds which amount to 4% of the portfolio and whilst they could be nationalised, if they do survive, the upside will be many times the low multiples they currently trade on. I think I would be failing in my job if I just bought safe defensive stocks – the market sees you coming and extracts a high price from investors seeking certainty. Rentokil is a classic recovery situation, along with 3i and Daily Mail Group. It’s important to try and remember that the value of a share is about the earnings and profits for the next 15 years, not 2009 in isolation. But, in aggregate, these higher risk positions account for around 12% of the portfolio – balanced out by the likes of Vodafone, which accounts for 6% of the assets.

I do believe buying good businesses at distressed prices is now the right strategy – you make all your money in a bear market; you just don’t realise it at the time. Looking at the portfolio today there are some great opportunities, shares that could rise threefold over the next three years and this is something I would not have said 18 months ago. It will continue to be bumpy, there will be accidents along the way, but the portfolio is very diverse for just such reasons. Volatility makes it feel uncomfortable, but the dynamics of this crisis means there will be further deleveraging and liquidity is likely to remain poor, meaning some sharp swings in prices. Hard as it may be, one needs to focus on the types of return available: if a share is likely to double or triple over the next 3 years or so, that’s an attractive proposition so whatever happens in the next six months needs to be seen in this context”.